What to Watch For in China in 2011

China had quite a year in 2010; in fact, quite the decade. I think it's safe to say that China ended the first decade of the 21st century in a very different place than parts of the developed world. It dusted off the effects of the "Great Recession" and emerged the world's #2 economy, surpassing Japan. Meanwhile, Europe seems to be gripped by uncertainty and waywardness, dealing a setback to one of the most momentous regional integration stories of the last half century.

2010 opened with the brouhaha over Google's threat to pull out of China, shortly followed by Beijing's muscular posture toward US arms sales to Taiwan, with threats to sanction US companies. Bickering over currency, an assertive Beijing exerting claims in the South China Sea, and finally a move on currency before the G20 in June punctuated the spring and summer. With a little reprieve, Beijing then careened into conflict with Japan over a fishing boat incident, which had the unintended effect of catapulting obscure metals called rare earths to dominate headlines. Of course, the crescendo came during midterm elections when a preponderance of anti-China political ads dotted websites and television screens, as well as a currency bill that wound its way through the House of Representatives. And of course, few could forget Beijing's ill-advised and stubborn protestation against the Nobel Peace Prize (if Liu Xiaobo was virtually unknown in China before this episode, he sure is well-known now). Yet the year's denouement was not accompanied by the rancor that defined Copenhagen last year, but a gentility that saw a China willing to compromise, helping to salvage the climate change process.

Whew, that's a lot, and I may have omitted items. So what's in store for 2011?

Other than President Hu Jintao's January state visit to Washington--on which I will write when the time arrives--one of the most important developments will be the final contents of the 12th Five-Year Plan and how China begins to execute it. The plan will be formally ratified by the Chinese legislature in March 2011, when the numerous moving pieces that compose the broad plan will be put into action. In a previous post, I've raised some questions to which the Chinese will have to address in the next few years in their plan, so I won't regurgitate them here. Instead, I want to draw attention to a recent op-ed by Yu Yongding, an Oxford-educated former adviser to the Chinese central bank, who offers a sober assessment of what's at stake for China over the next several years:

Painful adjustments needed to sustain advancement in the face of anemic innovation, slow tech upgrades and social tensions

China's per-capita income, at $3,800, has surpassed the threshold for a middle-income country.

But even as economists and strategists busily extrapolate its future growth path to predict when it will catch up to the United States, the mood in China became somber and subdued in 2010. Indeed, Premier Wen Jiabao sees China's growth as "unstable, unbalanced, uncoordinated and ultimately unsustainable".

Economic growth, of course, has never been linear in any country.

Throughout history, there are countless examples of middle-income countries becoming stuck in that category for decades or eventually falling back to low-income status. The Nobel laureate economist Michael Spence has pointed out that after WWII, only a handful of countries were able to grow to a fully industrialized level of development.

China's progress over the past three decades is a successful variation on the East Asian growth model that stems from the initial conditions created by a planned socialist economy. That growth pattern has now almost exhausted its potential. So China has reached a crucial juncture: without painful structural adjustments, the momentum of its economic growth could suddenly be lost.

I think Yu quite accurately captures the mood that percolates beneath the current optimism over a Chinese economic juggernaut, both internally and externally. Not to say that China will not see solid grow--most economists are still projecting enviable growth rates of 8-9 percent--but the sustainability of how it is growing is under serious scrutiny. People like Yu are increasingly warning against complacency that can lead to a middle-income trap or Japanese-style lost decade. Yu goes on to say:

After decades of rapid expansion, China has become the workshop of the global economy. The problem is that it is no more than a workshop. A lack of innovation and creation are the economy's Achilles' heel.

For example, in terms of volume, China has become the world's largest car producer, churning out 17 million vehicles this year. But the proportion of models developed by domestic carmakers is negligible.

In an era of rapid technological progress, creativity and innovation, the global economic landscape can change rapidly. Without a strong capacity for innovation and creativity, even a giant has feet of clay. And when a giant falls, many get hurt.

While China's living standards have dramatically risen over the past 30 years, the gap between rich and poor has sharply widened.

Income distribution has remained skewed in favor of the rich for too long, and the government has failed to provide decent public goods. With the contrast between the opulent lifestyles of the rich and the slow improvement of basic living conditions for the poor fomenting social tension, a serious backlash is brewing.

So arrives the 12th FYP, which in theory aims to tackle some of the structural challenges that will head off longer-term pain. But the outstanding question remains whether China's leaders will pursue the right policies with the kind of urgency necessary. Major economic adjustments are usually never pleasant, and most leaders would prefer to minimize the pain on the largest swath of the population possible during that process. The Chinese are no different in this regard, but how much heavy-lifting can they tolerate?

Yu and a similarly reform-minded lot are advocating temerity over timidity, likely in a bid to influence the direction of debate as there are forces inevitably arrayed against them. Plenty of interests in China eschew these changes that will involve taking away some of their wealth, likely prompting a vigorous defense of the status quo. There remains a window of opportunity to push forcefully for what Yu calls a "different road," as drafters of the plan continue to revise and churn until next year. Either way, an interest-based political and policy battle is likely under way that will shape how China grows over the next decade. We'll see how the story develops.

Damien Ma is a fellow at the Paulson Institute, where he focuses on investment and policy programs, and on the Institute's research and think-tank activities. Previously, he was a lead China analyst at Eurasia Group, a political risk research and advisory firm.